Illiquid, a thing to fear, or a benefit?

A modern portfolio disaster, a stock is purchased instantly online, but when it comes time to sell no buyers are available.

Illiquid - An asset that cannot be sold quickly because of a lack of ready and willing buyers.

"The value in travel - as in investing - is rarely found in the clogged main thoroughfares but in quiet side streets where few travelers care to go" - Richard Morals (Barrons, 10/13/12)

I am no stranger to illiquid stocks, my portfolio is full of them, I frequently dig through them for bargains, and many of the ones I find appear on this blog.  Illiquidity seems to be a modern, and in my opinion irrational fear born out of electronic markets, and instant decisions.  Investors have always been worried about getting into trades that they can't get out of, but the fear seems to be the greatest now, at a time when market volume is lower than ever, and some markets, like the pink sheets are the most illiquid.

I watched a video on Greatinvestors.tv where investor Paul Sonkin was interviewed on his view of the micro and nano-cap markets.  Paul's view is that ever since the financial crisis liquidity has disappeared, and investors are afraid to touch any stock which they can't quickly liquidate.  Paul's points are very valid, and a concern for portfolio managers, and professional investors who might need daily liquidity for redemptions if the market turns.

I want to approach the issue of illiquidity differently, I want to talk about why I don't think an illiquid stock is to be feared, and how many opportunities lie in illiquid assets.  The key is prudent portfolio management, which I discuss at the end.

Benjamin Graham in Security Analysis discusses that investors should approach investing with the attitude of a businessman.  The idea is to analyze companies as they are, real businesses, and not pieces of paper that are traded.  The decision to invest should be made as a business decision, not as a trading decision.  I think the same approach and attitude should be taken with regard to illiquid assets.

Let's forget about the stock market, and buying stocks with a mouse click for a few minutes.  Imagine an opportunity is presented to buy a stake in a local business.  The local business has been growing at 10% a year, is profitable, and has a good reputation.  The owner needs the money now and is willing to sell a stake in the business for half of book value, and an effective P/E of 5x.  As an outside investor you wouldn't get a salary, but the company pays out a portion of their profits as dividends.  After some due diligence, and a discussion with the owner you decide to purchase a stake and write a check.  This process was a business decision, approached like a business person.  When the stake is purchase most likely the thought of liquidating the stake quickly isn't considered, because it doesn't make sense.  People who buy stakes in brick and mortar businesses don't wake up one day and decide to dump everything they own because they're scared.  Most private business investors thoughtfully consider each investment, and realize they can't undo a mistake quickly, so they are extra careful before investing that their decision is the right one.

I think as investors we need to approach holdings in a similar manner.  From buying 1 share to buying 100,000 shares, a share is an ownership interest in a company, no matter what the size.  Unfortunately we often lose sight of that and look to flip it quickly.  If we're honest with ourselves, I'd guess that every reader would ideally like their holdings to appreciate 50-100% the day after they buy them.  I know I'd prefer that to holding patiently for years, who wouldn't?

I think patience in the market has been lost with the electronicization of markets.  Utilizing online brokers, investors are able to buy and sell stocks and bonds instantly.  If an order is placed to sell a stock and it takes a few hours to execute investors become impatient.  In the past stock ownership meant having physical certificates of companies; buying and selling wasn't as quick of a process.  When an investor decided to sell they would have to call their broker, notify them of their intention to sell, then mail the broker the physical certificate.  This whole process could take a few days to a week.  If it took three or four days to execute the trade it wasn't a big deal.  Patience was built into the system, unfortunately now we have a system that is built around instant decisions.

If I had to guess, I would say most readers will read this post and agree, yet will continue to disregard illiquid assets.  Because of this some incredible bargains exist in illiquid assets.  My example above isn't fabricated out of nowhere, companies like this exist.  I've written about Hanover Foods in the past, they're illiquid, and trading at a P/B of .38x with a P/E of 5.5x.  Or what about RCW Manufacturing, with a P/E of 5.21x.  Of course we can't forget about Randall Bearings, P/E of 1.55, P/B of .19x.  Deals like this will never exist on the NASDAQ or NYSE except in a period of extreme pessimism.  If any of these situations were approached as a private business buyer instead of as an outside investor would your reaction be any different?

Maybe this post has been somewhat convincing in that you feel it's worth considering illiquid assets.  The question remains, how do you approach this from a portfolio perspective?  First I think an investor in illiquid assets needs to demand one of two things, either a dividend, or an absolute cheapness.  When I say absolute cheapness I mean stocks that have $100 in assets selling for $30.  These aren't Barron's companies selling at $33 that have the potential to move to $35 in the next year.  These are stocks that own a coal mine worth billions selling for a few million, like Central Natural Resources.

The other criteria I mentioned is a dividend.  My experience has been that many if not most illiquid companies pay some sort of dividend.  Some companies pay generous dividends not found in listed markets, with yields north of 10%.  A dividend gives the outside investor back a portion of profits every year.  I personally prefer a dividend over absolute cheapness for illiquid stocks, but if the price is low enough I'll go for an insanely cheap asset.

The last thing to consider his how much of a portfolio should consists of illiquid stocks?  My own personal target is anywhere between 15-25% of my portfolio.  I would potentially go as high as 50%, but so far I've found enough liquid opportunities that illiquid stocks only make up about 10% of my total portfolio.

If an investor decides to devote their whole portfolio to illiquid stocks I would recommend they make sure most of their holdings pay dividends.  While they wait for value to be realized they'll at least realize cash flow out of the holding's profits.

One parting thought, for most investors, who aren't wealthy hedge fund managers, their house is their largest asset.  For the most part houses aren't liquid assets, but most investors aren't panicking that they can't sell their house at the click of a mouse.  Maybe we should approach our investments as we do our house, realize they have value, but that we don't need to sell it instantly.

Talk to Nate about illiquid stocks.

Disclosure: Long Hanover, RWC, Randall Bearings